Barack Obama and Co. are planning to launch their own version of economic “shock and awe” in the opening weeks of the new administration. Aside from the $825 billion stimulus package, which will be used to create 3 million new jobs and make up for flagging consumer demand; Obama is planning a financial rescue operation for banks that are buried under hundreds of billions of dollars of troubled assets. Spearheaded by Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers, the new program will create a government-backed “aggregator” bank that will purchase mortgage-backed securities (MBS) and other problem assets for which there is currently no active market. The proposed “bad bank” will do what the TARP program was supposed to do; wipe clean the banks balance sheets so they resume lending to consumers and businesses. Until the credit mechanism is fixed, the economy will continue slip deeper and deeper into recession.

This is not a normal recession where the mismatch between supply and demand will work itself out over time. The banking system is clogged and dysfunctional, the Wall Street funding-model (securitization) has broken down, global markets are in disarray and falling, and unemployment is steadily rising. The system is broken and can’t be fixed without intervention. The question is, what parts of the present system are salvageable and which parts should be scrapped altogether. So far, too much attention has been devoted to re-inflating the credit bubble and not enough to off-balance sheets operations, over-leveraged assets, SIVs, opaque hedge funds, unregulated derivatives contracts and a financial system that operates without guard rails or oversight. The Obama team is more focused on treating the symptoms than curing the disease. That suggests that their ties to Wall Street make them unsuitable for the task at hand. The job requires competent people who are free from institutional and class bias which prevent them from acting in the public interest.

While it is true that the banks need emergency triage; the underlying problem is falling demand brought on by stagnant wages. This can’t can be solved by making credit more easily available. In fact, credit expansion is what led to the present crisis. There needs to be a rethinking of wealth-distribution so that future crises can be avoided. The only way to maintain a healthy economy, without producing destructive speculative bubbles, is by strengthening the middle class via higher wages. That’s the key to sustained consumer demand. The recent attempt to bust the auto makers union indicates that many members of Congress believe that the economy can thrive even though a disproportionate amount of the nation’s wealth goes to the upper 5 percent. The current economic crisis illustrates the flaws in this argument.

Presently, the banks are sinking faster than the government’s efforts to bail them out. That’s why Obama asked Congress for the remaining $350 billion of the TARP funds. He knows that he’ll need to be ready to provide emergency funding for capital-starved financial institutions (like Bank of America) as soon as he is sworn in. The market for mortgage-backed securities, credit card debt, car loans and student loans is frozen. The Fed has started to purchase large amounts of these toxic assets, but to no effect. Bernanke’s purchase of agency debt–Freddie Mac and Fannie Mae–has pushed the 30-year fixed mortgage below 5 percent for the first time, but housing prices continue to tumble and sales are at record lows. The Fed’s monetarist lifeline has done nothing to slow the pace of defaults, foreclosures or bankruptcies. Money supply alone cannot reverse the effects of a collapsing credit bubble.

Economists are finally making realistic projections of the costs of the meltdown. According to the Wall Street Journal:

Roughly $2 trillion in losses for financial institutions. Originally, experts thought the losses would be no more than $200 billion, a small sum considering that 65 percent of mortgages were securitized between 2003 to 2007 representing roughly $4 trillion in additional mortgage debt. Clearly, with housing prices plummeting, foreclosures skyrocketing and millions of mortgages under pressure from negative equity; losses were bound to be significantly larger than originally predicted. The banks have no way of making up the $2 trillion of lost capital, which is why economist Nouriel Roubini says, “the banking system is basically insolvent.”

Up to this point, Secretary of the Treasury Henry Paulson has tried to keep critical banks functioning through capital injections. In theory, this allows the bank to lend even though it may be holding billions in toxic assets that are downgraded with every reporting period. As it happens, the injections have not increased bank lending at all. According to a recent report, the banks increased their reserves by over $600 billion in a matter of months. In other words, the banks are taking money from the Fed’s lending facilities and hoarding it for the tough times ahead. Naturally, this has angered Congress which feels that it was duped into giving away $350 billion with no guarantees about how it was to be used.

Summers and Geithner have decided to abandon the capital injection program and buy the bad assets directly. The costs to the taxpayer and future generations in terms of larger deficits, higher interest rates, less capital for private investment, and lower standard of living will be astronomical. Even so, the plan is expected to zoom through congress without any serious opposition just like the TARP.

Between the massive stimulus package and the so-called “bad bank” program; the economy could show signs of life by the 3rd Quarter, (If there is not a run on the dollar!) but who’s really served by these deficit-producing fiscal policies; working people or bankers?

Will these solutions address the growing wealth gap, which is greater than anytime since the Gilded Age? Will they “level the playing field” or create opportunities for upward mobility? Or are they just a quick-fix to get the country through a rough patch without social upheaval?

The Obama economic recovery plan is a misreading of the real problem, which is not the availability of credit, but debt. Bernanke, Summers and Geithner are approaching the issue from the wrong end; they want to stimulate the economy through credit expansion and more red ink. This is just more of Greenspan’s bubblenomics; the endless boom and bust cycle triggered by low interest crack sold to credulous speculators. The only ones who benefit are the Wall Street insiders who know how the cards are marked and then vamoose before the bubble pops. Easy money won’t reverse the deflationary slide from a deep recession. It’s time to rebuild on a solid foundation of rising wages, a stronger workforce, and a revitalized middle class. There’s only two ways to grow the economy; higher wages or credit expansion. The latter option has already been tried and it ended in disaster.

Still, don’t expect the Fed or the Treasury to be dissuaded by the facts. The Fed is presently purchasing mortgage-backed junk from Fannie and Freddie to push down interest rates so it can seduce buyers into going deeper into debt. Fortunately, most people are wise enough to see that it is not in their best interest to buy a home during the biggest real estate crash in history. In fact, most people already have more debt than they can handle, so they’re cutting back sharply on spending. Falling stock markets, battered 401Ks, and loss of job security have caused a fundamental change in consumer attitudes. Frugality is making a comeback while consumer confidence is at its nadir. It’s hunker-down time in USA.

The Fed’s low interest rates and other credit-enhancing inducements have been unable to stimulate spending. According to the Wall Street Journal:

“U.S. household debt, which has been growing steadily since the Federal Reserve began tracking it in 1952, declined for the first time in the third quarter of 2008. In the same quarter, U.S. consumer spending growth declined for the first time in 17 years.

That has resulted in a rise in the personal saving rate, which the government calculates as the difference between earnings and expenditures. In recent years, as Americans spent more than they earned, the personal saving rate dipped below zero. Economists now expect the rate to rebound to 3% to 5%, or even higher, in 2009, among the sharpest reversals since World War II. Goldman Sachs last week predicted the 2009 saving rate could be as high as 6% to 10%.

As savings increase, economists say, spending is likely to contract further. They expect gross domestic product to decline at an annualized rate of at least 5% in the fourth quarter, the biggest drop in a quarter-century.”

Summers and Geithner should pay attention to what’s going on in the country and change their approach. The US consumer will not lead the way out of this economic downturn. It’s physically impossible. The country is undergoing a generational shift from profligate consumerism to thriftiness. Stimulus alone won’t get people spending. Salaries will have to go up to make up for losses in retirement funds and housing prices; and the face-value of mortgages and credit card debt will have to be written-down. Otherwise, spending will continue to falter and the economy will tank. No economic recovery plan has a chance of succeeding if it doesn’t address these two key issues; higher wages and debt relief.

Naturally, the Federal Reserve does not want to deal with the underlying causes of the crisis. After all, they’re in the credit-peddling business. The Fed’s job is to generate business for the financial community, which means creating a favorable environment for credit expansion. In recent weeks, the Fed has provided billions of dollars to GMAC (General Motors finance arm) so that prospective buyers of GM vehicles can secure 0 percent financing even though they have bad credit scores. This is how the Fed stealthily perpetuates subprime lending even though it leads inevitably to disaster. The Fed is working a similar scam through the FHA where according to Business Week:

“The same people whose reckless practices triggered the global financial crisis are onto a similar scheme that could cost taxpayers tons more…

“As if they haven’t done enough damage. Thousands of subprime mortgage lenders and brokers—many of them the very sorts of firms that helped create the current financial crisis—are going strong. Their new strategy: taking advantage of a long-standing federal program designed to encourage homeownership by insuring mortgages for buyers of modest means.

You read that correctly. Some of the same people who propelled us toward the housing market calamity are now seeking to profit by exploiting billions in federally insured mortgages. Washington, meanwhile, has vastly expanded the availability of such taxpayer-backed loans as part of the emergency campaign to rescue the country’s swooning economy.(FHA-Backed Loans: The New Subprime, Chad Terhune and Robert Berner, Business Week)

Unbelievable; one Fed sting after another. And when they blow up, as they often do, the taxpayer foots the bill. This shows that the Fed has only one arrow in its quiver; easy money. Bernanke’s panacea for joblessness, falling demand, plummeting asset prices and deflation is credit expansion–one size fits all.

In a recent Financial Times op-ed, Lawrence Summers showed that he’s resolved to tackle the central issues head on. This comes as something of a surprise since Summers was one of the main proponents of deregulation. Here’s what he said:

“We need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatized gains and socialized losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive. The policies that are most effective in helping to support demand are those that help households struggling either because of low incomes or because they have recently lost part of their income. Recent events also remind us that individuals can become impoverished or lose health insurance through no fault of their own. This reinforces the need for people to have basic health and retirement security protection regardless of what happens to their employers.” (“The pendulum swings towards regulation”, Lawrence Summers Financial Times)

Summer’s article is an indictment of the finance-driven system that he helped create. He sounds more like Robert Reich than Milton Friedman, but has he really changed that dramatically or will he continue to serve the interests of Wall Street once he’s in office?

The test for Summers will be how he goes about fixing the banking system. That will prove whether he’s sincere or not. As expensive as it may be, recapitalizing the banks and purchasing their bad assets is the easy part. The hard part is to establish a facility, like the Resolution Trust corporation (RTC), and use it as a morgue for winding down insolvent banks. It requires someone who can ignore political and institutional pressure and be impartial in deciding whether a financial institution can be saved or not. The bad banks have to be put out of their misery. It’s is a tough job, but it has to be done. Otherwise, zombie banks will suck up vast amounts of public money even though they’re unable to effectively distribute credit to consumers and businesses. That’s what dragged Japan’s economy into the “lost decade”.

Anil Kashyap, of the University of Chicago Booth School of Business summed it up like this:

“Policy makers should stay focused on recapitalizing the banking system…. Financial firms won’t start lending again until their balance sheets are in better shape. But BAD BANKS SHOULD BE SHUT DOWN or nationalized more aggressively. “It is a complete waste of taxpayer money to bail out somebody who is insolvent”.

The good news is that there is a solution. The bad news is that it will be an excruciating undertaking to turn out the lights at hundreds of banks where the liabilities greatly exceed the assets. But that’s what it will take to get the banking system back on its feet.

The Obama stimulus package is a good place to start, but it skirts the core issues of wages and debt relief. Both of these will have to be factored into any plan that, as Larry Summers says, “seeks to ensure that any future prosperity is inclusive.”